The Crisis Goes From Bad to Worse

By

Mark Gongloff

Updated Oct. 12, 2008 11:59 p.m. ET

The first step in recovery is admitting you have a problem. The carnage on Wall Street suggests investors have taken that step -- accepting the reality that the economy is in or headed for a recession, possibly a severe one.

The next step, which many people are loath to face, is figuring out what to do with their now sharply diminished investment dollars.

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Tim Foley

History would suggest that, for some investors, the stock market might be an attractive target despite the natural temptation to flee. That sounds downright crazy right now, considering the Dow Jones Industrial Average is in free-fall, having plunged 40% from its all-time high a year ago.

The Dow tumbled 18% last week, the biggest one-week decline in the average's 112-year history.

But past recessions show that stocks typically suffer the most before the economic downturn begins and start to recover at some point after it begins.

Lessons of the Past

Each of the past six recessions has been accompanied by a bear market, with the Standard & Poor's 500-stock index losing, on average, 31%. By that measure, the stock market's current decline -- with the S&P 500 down 43% from its peak -- is already worse than usual.

But stocks lost only 3%, on average, between the start and end dates of those recessions, as defined by the National Bureau of Economic Research. Stocks gained, on average, 6% during the six months after the recessions ended. That suggests buying and holding stocks during a recession is not a bad idea.

The NBER defines a recession as a long-lasting, widespread, "significant" decline in economic activity. The NBER often makes its determination well after a recession has begun -- and sometimes after it has ended.

For investors, each recession is different. The 2001 recession, for example, was accompanied by a prolonged bear market, in which the S&P 500 fell 49% in total, including an 8% decline during the recession. The market didn't hit bottom until nearly a year after the recession ended, and then went through several volatile months before a recovery took hold.

ENLARGE

Stocks fell 23% during the 1973-1975 recession, representing a big chunk of their total 48% decline in that era's bear market.

The current bear market is quickly catching up to those in terms of severity. But there are some key differences that suggest a bottom might be nearing.

Before the 2001 recession, the dot-com boom had left stocks wildly overvalued. When the bear market began in March 2000, the ratio of the S&P 500 stocks' prices to their past year's earnings -- a closely watched measure of market value -- was nearly 33, according to research firm Birinyi Associates. Today, the S&P 500 trades at about 16 times trailing earnings -- roughly its historical average.

Before and during the 1973-1975 recession, interest rates were in the rafters, making savings accounts and bonds more attractive than stocks. Today, the Federal Reserve's target interest rate is just 1.5%, theoretically making stocks much more attractive.

Caution Still in Order

But the current bear market and economic turmoil have their own unique features that should probably keep investors cautious for a while. The global financial system is in the grips of a crisis not seen since the Great Depression. Investors have little idea what will fix the problem and aren't sure policy makers know, either.

Investors also are unsure how much damage has been done to the economy by a credit crunch that has intensified in recent weeks to a credit freeze, making it difficult for companies to do business and for consumers to borrow money for spending. The market is already priced for a recession, but no one knows for sure how long the recession will last or how deep it will go.

Policy makers around the globe have all their guns trained on the current problem, and most observers expect them to avert a depression, which is essentially an unusually severe and long-lasting recession. That's one reason why it's probably too late to sell stocks now, if investors have already ridden them this far down.

Still, it is virtually impossible to know how much corporate profits will suffer in the months and quarters to come. That's one reason many analysts recommend investors stay defensive. Among stocks, that means holding companies that can make money regardless of the economic climate, particularly makers of consumer staples such as canned food and toothpaste.

The Case for Bonds

When the credit crunch begins to ease, high-grade corporate bonds could be attractive. Investors have fled from any credit-related risk and, as a result, the bonds' prices are very low and their yields very high.

"In an environment where we have uncertainty on earnings and we have a stock market not table-pounding cheap, the bond market is offering a very competitive alternative," says Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

Stocks of companies in emerging markets such as China and India have been pounded even harder than U.S. stocks, a trend that could reverse sharply when the tide finally turns. Right now, however, even the bravest and deepest-pocketed investors aren't jumping into such investments. Some observers warn the time for taking bigger risks might not arrive until mid-2009.

"A large number of assets are extremely cheap," says Mark Cliffe, a London economist with Dutch financial-services firm ING. "But they could get cheaper."

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